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Koesterich: This Bull Market Can Survive Higher Rates

The U.S. economy and stock market should be able to absorb a measured rise in rates starting next year, but investors should expect subsequent raises to come soon after, says BlackRock's Russ Koesterich.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We are at the Morningstar ETF Conference. I'm joined with Russ Koesterich, the chief investment strategist from BlackRock.

Russ, thanks for joining me.

Russ Koesterich: Jeremy, thanks for inviting me here today.

Glaser: Certainly the Federal Reserve has been one of the key focuses of the market recently. We heard from them today that rates are going to stay low for "a considerable time," still using that language. What's your outlook on rates? What do you think the Federal Reserve is going to do?

Koesterich: There are a couple of things to consider. The Fed did keep the "considerable" language in the statement, but in the press conference, Chairwoman Yellen actually went to some pains to point out that there is not a hard time frame associated with that. What the Fed is telling us is that it's data dependent. And if you look at their estimates, they are a tad more hawkish than they were back in June. So we're seeing some reflection of the fact the economy is strengthening, at least on a cyclical basis. That suggests there will probably be a Fed hike sometime in the first half of 2015.

Maybe more important than the initial date is that subsequent hikes might be a bit quicker than the market expects. I think that's part of what you need to consider--not only the date of the initial hike, but also how does that progress from there? Where do you wind up? Those are the other components of this that investors want to consider.

Glaser: But you do see the U.S. economy has been strong enough to support higher rates?

Koesterich: I think it has. We had a weak non-farm payroll print in August. But that aside, if you look at the bulk of economic data over the last two or three months, there is clear evidence of some acceleration in the economy, particularly from where we were in the beginning of the year.

In addition, many of the leading indicators--things like new orders, initial jobless claims--they're telling you that you're likely to keep some decent momentum in the second half of the year. Most of the cyclical factors that we watch are improving. At this point, it's not clear that the Fed can fix the structural issues--and there are structural issues--through lower rates. We do think that the economy is strong enough to justify starting to raise rates sometime next year.

Glaser: If the economy is looking a bit stronger, rates may be going up sometime in 2015, what does that mean for U.S. equities? Where do you see valuations? Are they supportive right now?

Koesterich: I think valuations are supportive as long as you have the assumption that rates are not going to melt higher. Our assumption is the Fed will start to raise rates. There will be some backup in the long end of the curve. But let's remember we're still lower than we were when we started the year. If what we're talking about is a measured increase by the Fed, and some modest backup of long-term rates, and that happens in the context of an improving economy, which is what we've seen so far, the equity market could withstand that.

Valuations are not cheap. I think that does affect the long-term return, but they are not so high that a 3% or 3.5% 10-year yield … I don't think that's going to derail this bull market.

Glaser: Are valuations pretty even across sectors and across market cap size? Are you seeing pockets of value in the U.S.?

Koesterich: Well, there aren't many places anywhere in the capital markets where you see screaming bargains. We have had a bull market for five years, rates have been low for longer. This really has pushed people into risky assets, and as a result most valuations are somewhere between fairly valued and stretched.

That said, we do see differences. In general a couple of big themes. In the United States, larger companies look cheaper than smaller companies. Also, at least historically, they have been more resilient when the Fed starts to raise rates. In other words, their multiples tend to hold up better.

The other big theme we think about is cyclical versus defensive. Many of the more defensive parts in the market--I am thinking about, for example, utility companies--their valuations are a bit more stretched because investors have been looking at that segment of the market to get income. So in general we find that the more cyclical companies--technology, financials, parts of manufacturing, energy--look cheaper than many of the defensive sectors.

Glaser: Outside of the U.S., are you seeing any more values? I know in the past you have mentioned Japan as an area that you think looks pretty good.

Koesterich: Within the developed world, it really is hard to find anything that's trending below its long-term average. The United States is clearly on the expensive side. Europe is probably somewhere close to fair value. Japan looks to be really the only unambiguously cheap market out there. On a price-to-book basis, for example, it trades at roughly half the U.S. valuation.

Now, given slower growth, given many of the structural headwinds in Japan, Japan should be cheaper, but it doesn't necessarily need to be that cheap. When we compare it to other parts of the developed world, it does seem that not only are valuations low, but there are some other tailwinds that will benefit Japanese stocks. A very accommodative Central Bank that's going to keep monetary policy ultra-loose at least in 2015, arguably some reallocation of pension assets from the large Japanese pension funds, and some evidence of corporate reform. Taking that in aggregate, we do see some good opportunities in Japanese equities.

Glaser: How do you feel about the currency then? How does that play into your thesis?

Koesterich: We think that the currency probably is going to weaken a bit. But we don't think that the view on Japan is predicated on a much weaker currency. In other words, if we do see further weakness in the currency, that probably is a bit of a tailwind for the more cyclical exporting parts of the Japanese economy. But as I mentioned, there are lot of reasons Japanese stocks can go up that have nothing to do with the yen. Certainly if you look at where the yen is today at 107, 108, I think that's supportive even if it doesn't go any lower.